Return on Capital Super Heroes
Featured in the 2nd June edition of 3L&3S
American fund manager, Tom Machperson of Nintai Partners, highlights something that many of us who manage money know but never fully acknowledge i.e. “Managers who are frugal, both in their personal lives and in their compensation, generally run companies with higher returns on capital than those overseen by the most highly compensated managers.”
Nintai Partners’ number crunching suggests that CEOs who are paid less generate more Return on Capital: “We chose 36 companies from the top decile of the S&P 500 and 49 companies from the top decile of the Russell 3000 and calculated return on capital for the years 2009 to 2013. We chose the same amount for the lowest decile. In addition, we wanted to see if individuals who are compensated at either the highest or lowest decile had a different tenure within their respective companies. Last, we were interested to see what happened to the company’s return on capital after that management team had left. (The pool of candidates was smaller here simply because not everyone has left yet.)
It turns out there was a strong correlation. The numbers seen below show that management who are compensated the least have a dramatic – and positive – impact on ROC. I should note this applied in every industry sector listed (in the Corporate Sector Make Up). The lowest 10% in compensation achieved an average ROC from 2009 to 2013 of 17.3%. The highest 10% compensated managers achieved a ROC of only 11.4%. Additionally, the lowest paid managers stayed on in their CEO position nearly 10 years longer. As an investor, not only does your holding managed by the lowest compensated managers generate a higher ROC, but it achieves it for a longer period of time.”
The same finding apparently holds true in fund management – lower paid fund managers generate better returns: “It turns out the data show that managers who are frugally compensated have a tendency to generate much higher return on capital than those who are lavishly compensated.”
So why do we see this correlation? Is there causation here i.e. are lower paid CEOs and fund managers doing something through their frugality which is helping their firms make more money? Macpherson sees three effects at play:
· “….some individuals run a tight financial ship throughout their lives. This type of tight-fisted approach to spending can run through an entire business, creating extraordinary internal returns (such as return on capital, return on equity and return on assets) as well as investor returns….
· …managers who faithfully showed up on the lowest compensated list year after year remained at their post far longer than those who were the highest compensated.
· …While return on capital decreased slightly after the departure of a lowest-compensated manager, generally the company continued to outperform companies with the highest compensated managers. This persisted over the next five to 10 years in nearly every case. The values of the cheapskate CEO had a lasting effect.”